With the Great Recession in the rear view mirror, the Midwest is bustling with deal activity today. To gain a deeper understanding of what's happening in the Midwest and how events are impacting dealmaking activities, Mergers & Acquisitions recently gathered a group of M&A professionals. Hosted by Mergers & Acquisitions and sponsored by Plante Moran, Quarles & Brady, Monroe Capital and Huron Capital Partners, this roundtable offers valuable insight into the opportunities and challenges facing dealmakers in the Midwest and what lies ahead for deal makers looking to transact in the Midwest. The following is an excerpted transcript of the discussion, moderated by contributing editor Danielle Fugazy.

What does the Midwest have to offer companies?

Gretchen Perkins, Huron Capital Partners: First of all, the Midwest has a very educated and talented workforce. We have great public schools and great universities as well as robust trade school programs that produce this workforce. It's all about the talent. We have the talent and we retain that talent here because the Midwest offers a unique bundle of advantages regionally that are attractive. Relative to other areas of the country, the Midwest is an affordable place to live with great outdoor recreation. And importantly, the central geographic location of the Midwest is advantageous to companies. In my state of Michigan, for instance, we are located within 500 miles of over half of the markets of the United States and Canada.

Ted Koenig, Monroe Capital: The biggest difference in the Midwest now is that never before have Indiana, Michigan and Wisconsin been right-to-work states. Ten or 15 years ago it never would have happened. This is a very business-friendly situation now.

Patti Hutter, Quarles & Brady: In the last year or two, we have started to see a political shift in the Midwest. Along with the passage of right-towork, some of the legislatures are also trying to push through tax reform to make the states more desirable for business. In a recent study, Indiana was listed among the top 10 most favorable tax states in the nation. As other Midwest states follow suit, investors will become more interested, or re-interested in the region.

What types of businesses are located in the Midwest?

Perkins: Certainly manufacturing because we have the talent. The state of Michigan has the highest concentration of engineers and skilled tradesmen in the nation. Ohio, Illinois, Wisconsin are very similar. Our manufacturing heritage has bred a population of people who make things, know how to figure out how to make things work or make them work better. And that is the definition of innovation. This spreads into far more than just manufacturing. This is the type of talent pool you need for any business to grow and thrive.

Dennis Graham, Plante & Moran: The Midwest has a reputation as the Rust Belt, but that is really beginning to change. Companies in the Midwest are increasingly focused on technology and advanced engineering. For example, what you are seeing, particularly in the automotive industry, is the rise of connected mobility. The vehicle is becoming a center of connectivity with other devices and technologies. These innovations are being developed and led by companies in the Midwest.

Hutter: There is also a good concentration of health care and health care manufacturing businesses in the Midwest. We also now see a growth in the number of technology companies in the Midwest, which is a result of businesses shifting their focus after manufacturing was hit so hard. The Midwest also has a substantial amount of long-standing family-owned and closely-held businesses that don't necessarily have new organic growth opportunities readily available. There is a real opportunity for investors to infuse capital and help take those businesses to the next level.

Koenig: The Midwest has historically been a very active deal community because many of these privately held businesses have been located there. The Midwest probably was hurt disproportionately by the recession. And a lot of jobs were lost. The Midwest was forced to retool from a job standpoint so you have more services businesses now. Detroit has done a good job reinventing itself, as has Chicago. Wisconsin is doing a good job of attracting more technology- type businesses. And any time you have a good university system it drives a lot of innovation.

How is the region faring today?

Perkins: Very well. According to the U.S. Bureau of Labor Statistics, the Midwest currently has the lowest regional unemployment rate at 5.1 percent. Some of this of course is attributable to the general rebound in the manufacturing sector. As the economy has recovered, people start spending money again, driving demand for more goods. Additionally, companies in the region have retooled and have expanded their talents into other sectors. For instance, there are many former auto suppliers that are now supplying the aerospace sector.

Graham: Prior to the Great Recession, light vehicle production in North America was around 17 million units; in the depths of 2009 and 2010, it got down to about 10 million units. It's rebounded. This year light vehicle production will probably be around 16 million units, so very close to what it was pre-the Great Recession.

Is reshoring adding to growth in the Midwest?

Graham: You are definitely seeing a lot of reshoring activity. Production is coming back from China and Mexico to the United States. The three key drivers of that are increasing energy costs elsewhere in the world, wage rate equalization and supply chain security. In particular, supply chain security has become much more of an issue than it was in the past. As manufacturers and inventories become leaner, supply chain security is a much bigger issue. Reshoring and growth is also driving an increased demand in the skilled production trades: electricians, tool and die makers, etc. More highly engineered products demand a more highly skilled labor force for production.

Koenig: In addition to that, while labor rates may not be as good as in some parts of the world, the United States has the lowest-cost oil, natural gas and electricity of any developed country in the world, which is amazing.

In every state today, it's hand-to-hand combat to attract jobs because every state is running a deficit. Every state wants new sales tax, new sales revenue. So Wisconsin, Indiana, Ohio, Illinois and Michigan fight it out day to day for companies' locations. And companies are smart. They pit each state against each other and they see who can provide the most incentives and then decide where to set up shop.

What types of deals are getting done in the Midwest today?

Graham: Coming out of the Great Recession, you saw a lot of horizontal merger and acquisition activity - companies buying competitors and merging them together for production purposes, to create synergies and to reduce cost. Now you are seeing more vertical integration driving deals -companies looking to get new technologies, into new markets, add a skill set and/or customer base to their company that they didn't have previously.

Corporates spent time recovering, rebuilding their balance sheets and reserving cash. They ended up with stronger targets to take to market. As a result, what we are seeing today is that there is, once again, availability of good targets. The competitive nature of the market is showing us that there are probably still more buyers than sellers out there, but there are higher-quality targets available today. Those Midwestern companies that survived the downturn by cutting costs or by rethinking the way that they do business and by innovating are much more attractive investment opportunities.

Hutter: When the downturn occurred, it was a very slow deal market for a number of years. The deals that were getting done were primarily distressed, or if businesses were being sold, they were being sold at highly-discounted prices. And that led to a lot of companies that didn't have to sell just sitting it out.

How is the availability of credit impacting dealmaking?

Graham: It is having both positive and negative impacts on deal activity. Obviously it allows for acquisition leverage that helps get deals done. But, availability of credit is such that people are able to take chips off the table without giving up control. There have been a lot more dividend recaps among private equity groups and family-owned businesses.

Koenig: What you are seeing is that companies that would have otherwise sold in the last business cycle aren't selling because of the recap potential. It's happening quite a bit. Most of the private equity-funded deals get recapped two or three years after the deal happens. The investment banks have gone out on an aggressive basis, as have the lenders, to companies directly and offered them money for dividends, recapitalizations and refinancing transactions. And there have been large number of refinanced transactions.

What is driving deal volume in the Midwest today?

Graham: It's an old adage, but the three primary drivers of merger and acquisition activity are credit, capital and confidence. Credit is widely available at low interest rates and you are seeing creative financing structures. Capital is also widely available. There are some great private equity groups out there, like Huron Capital, looking for deals. Capital is available from both private equity groups and strategic buyers. But really the big difference in the Midwest deal market from two years ago is a return in confidence. We are seeing more deals done in the Midwest and not just by PEGs from the Midwest. We are seeing deals done by funds from the East Coast and the West Coast also.

Graham: Inbound investors are definitely a bigger part of our practice than they have ever been- in particular there are a lot of Asian companies with U.S. dollars to spend. So even with the foreign currency fluctuations, they have a lot of dollars in their pocket that they are now using to acquire assets in the United States.Hutter: We are also seeing more foreign investment in the Midwest. There are more foreign bidders in Midwest-based deals than I have seen in some time. The dollar is on the upswing but that has not so far hampered foreign investment.

Koenig: There are many more foreign manufacturers in the Midwest today. Just take the auto industry. Volvo is here, Mercedes is here and BMW is here. Toyota has been here for a long time. All these companies historically borrowed in dollars. As your dollar costs go up and you pay for your parts in dollars, unless you are in a place where you can manufacture in dollars, as the dollar gets stronger, you get whipsawed. You will see a trend of more and more companies that are overseas putting plants in the United States to take advantage of electricity, gas, oil, vendor issues, supply-chain issues and the dollar. And the Midwest is a great place to be because of the historic skilled labor pool.

Perkins: Much of it is due to timing. Our region has a more than average amount of manufacturing, which was hit harder during the downturn. Now we are four years out and companies are posting better earnings. 2011 was better than '10, '12 was better than '11 and so on. We are now at a point where many companies have four years of improving earnings to take to potential buyers. These companies wouldn't have done that two years ago. Many wanted to get to pre-recession levels. And echoing what Dennis said, the low cost of capital fuels deal valuations and in turn, volumes.

Who is most active in the region, private equity firms or strategic acquirers?

Graham: In the last couple of years, you have definitely seen a rise in competition for transactions with strategic buyers bidding aggressively on deals. Strategic buyers have been able to pay down debt, have a lot of cash on their balance sheets and are able to justify higher multiples based on synergies with target companies. In reaction to that, you are seeing private equity groups do what private equity groups do: finding creative ways to get deals done. You are seeing private equity groups focused on more carve-out transactions because carveout transactions are, by definition, noncore businesses to other strategics. And you are seeing also private equity groups focus on add-ons for existing portfolio companies in a size and a manner that they did not previously. They are much more aggressive on this front. And private equity groups seem to be much more willing to do smaller tuck-ins than they were doing a couple of years ago. They will do deals with vertically integrated businesses they wouldn't have necessarily considered part of a platform strategy previously. It's really a reaction to the change in increased competition from strategics. These changes are allowing private equity groups to still get deals done in this highly competitive market.

Perkins: You see much more add-on deal activity in the private equity ranks now. In the past 10 years with the Great Recession and the slow recovery we have had, it's become harder and harder to achieve top-line growth organically. A good way to get top-line growth and improve margins is to make add-on acquisitions and integrate companies properly.

Koenig: My thesis is that private equity has fundamentally changed. Private equity is a great business, but at the end of the day, if you are not generating returns for LPs, then it is not a great business. And if you look at the last 20 years, the top quartile private equity funds generated about a 14 percent return. There are a lot that were better than that, but there are a whole lot that have done worse. The question becomes how does private equity deliver returns to LPs? The answer is that you can't deliver returns to LPs if you are paying 9, 10, 11, 12 times Ebitda for every one of your companies. Going forward, I believe that the private equity industry will continue to buy platform companies for 8, 9, 10 times, which is what's happening today. However, to average down that multiple to generate an acceptable return on your investment capital is to do add-ons, tuck-ins, plug-ins, tack-ons, whatever you want to call them, at 3, 4, 5 times purchase price multiples. What you are doing is taking a 10 times multiple and averaging it down. You can then sell at 8 or 9 times and make money.

Perkins: We are doing smaller deals in general because we are priced out of some of the larger deals. A good example of that with us is our energy efficiency engineering platform. It's called Albireo Energy. The initial platform that we purchased was smaller than our stated minimum, but we were comfortable doing so because we were backing a great executive, Phil Bomrad, with decades of experience in the space and we knew we had plentiful add-on opportunities to pursue. It is a classic fragmented industry. In under one year since closing, we have completed three add-on acquisitions.

Graham: It comes back to the competition for deals with strategic buyers. Private equity groups have to get creative and broaden their focus beyond their typical mandates.

Perkins: Smaller deals command smaller multiples, and that is a fact. You can really create value if you start out with a smaller-size platform at a smaller multiple and then add on many more at small multiples. It's just harder, because you are doing multiple transactions to get to the same place from a size perspective.

Hutter: At Quarles & Brady we represent a lot of true middle-market companies. We have seen in some of our recent sell-side deals private equity players that would not typically have participated in the true middle-market deals coming to the table and making bids, and not just exploratory bids, but meaningful bids.

Koenig: Availability of financing also drives transaction volume. It's like the old adage in the real estate industry: If you give a real estate developer money to build, the developer is going to build houses. This cycle and the last cycle really haven't changed that much in terms of transactions. In '04, '05, '06 there was a large amount of deal activity, and we are seeing another large amount of deal activity now. The biggest differential, though, is who is providing the financing? In the last round it was primarily banks. And deals were getting done with three parties: banks, mezzanine funds and private equity funds. Today it's very different. The regulators have really discouraged the banks from playing in the transactional finance business leading to the rise of non-regulated financing markets. The business development company market has blossomed in the 10 years. There are now 53 public BDCs that are focused on financing buyouts and financing transactions. And in addition to that, the mezz funds that existed in the mid-2000s have largely been disintermediated. Today you will see in many two-party transactions-a private equity fund will cover the equity portion and a non-regulated financing firm, such as ours, will handle the entire debt part of the capital stack. Probably 75 percent of our transactions today are unitranche transactions where we are the only lender in the capital structure.

What are you seeing in terms of deal terms?

Hutter: As a result of what is a competitive market, we are certainly seeing more seller-favorable legal terms. We are seeing deals getting done with more favorable indemnification terms - true escrow caps, smaller escrows, bigger baskets, shorter survival periods and lighter representations and warranties. We are seeing protracted diligence processes. The increasing prevalence of the use of representations and warranties insurance is helping to drive all of this as well. Buyers are using it as a tool to distinguish their bids while backstopping their risk. We've seen buyers proactively including the purchase of a policy in their indication of interest. On the flip side, sellers are using it as a way to lessen their risk in the deal and to reallocate their risk. Sellers are putting sell-side draft documents out there that include indemnification provisions linked to these policies. The use of R&W insurance has skyrocketed in the last 18 months and the market, both buyers and sellers, is embracing it. It is a sellers market right now and I anticipate that will continue for the near-term.

Koenig: We are looking at each deal and where appropriate, we are encouraging, if there is a representation and warranty diligence issue, that the buyers to go and insure that risk if they can. One example is environmental insurance. This simply wasn't available 20 years ago. And now, environmental insurance is available for virtually every transaction. Even for a bad, dirty transaction, there is insurance available. You can get tax indemnity insurance for withholding taxes. You can get normal rep and warranty insurance. This is all good for lawyers and deal professionals. And it's good for lenders like us because we can underwrite a deal much more aggressively in a situation where we see a problem. That is covered by insurance. And the other thing that we see is much shorter periods for indemnities and holdbacks and much more focus on getting as much cash as possible at closing. In the last cycle, there were a lot more delayed payments, whether it was in the form of earn-outs or seller notes. But in a frothier market, it's hard to force that to happen. The sellers are selling off of pro forma adjusted Ebitda as opposed to actual historical Ebitda. It creates a lot of incentive for everyone to be careful.

Hutter: It is always interesting to see in the negotiation process who pays for the policy.

Perkins: It is our experience that the buyer pays.

Hutter: I agree, but we have had some buyers actually ask for the sellers to buy the policy. The argument for seller pay is that there is no exposure outside of your escrow. I've seen it both ways. The other thing the insurance policies really can help with is the timing of closing, because you are not necessarily spending so many lawyer hours negotiating indemnities and deal terms back and forth. The insurance can move things to closing much more quickly, which can work to the advantage of both of buyers and the sellers in the transaction.

What are you expecting on the dealmaking front in the Midwest going forward?

Graham: The Midwest is a great market for investing right now. We have a very active deal market and continue to do a lot of transactions. There are opportunities for all sorts of investors. The key to success in investing in the Midwest is understanding the fundamentals of the industry that you are investing in, particularly around industrial, manufacturing or automotive companies. You need the support of service providers that understand the fundamentals and the relative competitive advantages in the industries that you invest into. For example, in the automotive industry, having transaction advisory service professionals that understand tooling accounting for manufacturing is critical. There are service providers from other areas of the country who may not have the depth of understanding around these types of specific industry fundamentals.

Hutter: Understanding the Midwestern culture is very important too. The Midwest is a unique culture, and when the investors, financing sources, law firms, service providers and other advisors have a good foothold in the Midwest and really understand the business culture, they do have a distinct advantage.

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